The old saying goes that nothing is as certain as death and taxes. However, there are still great debates about what a tax system should look like, both in theory and in practice. Some principles have been established, but the final design still depends on numerous elements, only some of which are economic, and a large number of them are social or political.
The biggest debate is between the proponents of proportional and progressive taxation, which in its essence boils down to the debate between efficiency and inequality. At the beginning of the transition reforms, in most countries the current that advocated efficiency won and proportional taxes became the rule in almost all countries of Central and Eastern Europe (CEE).
Proportional VS progressive
In the US, Al Capone liked prison not because of organized crime, but because of tax evasion. But the fact that tax must be paid does not mean that it is clear what the amount of tax should be. In proportional income tax systems, everyone pays the same tax rate, regardless of how much they earn.
On the other hand, in progressive systems, the level of the tax rate depends on how much you earned – with the increase in income, the tax rate also increases. In the CEE countries, a good example of a proportional income tax is Estonia with a rate of 20% for all income levels, and progressive Slovenia with tax rates of 16%, 27%, 34%, 39% and even 50%, depending on the income level.
Proponents of the proportional system claim that it is better because it is easier to apply – it is cheaper for the companies themselves because it reduces their administration costs, but also for the state itself, which should control the implementation of tax regulations. This is especially important in countries that have weak administrative capacities – read incompetent, corrupt, poorly educated and paid civil service where nepotism is more present in employment and advancement than meritocracy – because then there is no one to implement those regulations.
In such an environment, one arsin (in the form of one same tax rate) for all is much easier to apply. Another important argument concerns economic efficiency: people respond to incentives. People value not only the money they can earn, but also the free time they can spend outside of work. If the tax burden is such that it overtaxes labor income, then the most successful will have less incentive to work and more to spend time in leisure.
The size of these effects depends directly on the tax rates – if the progression is low, they are likely to be weak in aggregate, but if the progressivity of the tax rates is very high, the effects will become visible very quickly. And they have a negative impact on economic trends – if the most productive parts of society start working less because it no longer pays them, it will be felt everywhere. For example, if you have to have a demanding operation, it would certainly be important for you to have it performed by a top doctor with experience, and not his younger, inexperienced colleague, because the latter is the first to go fishing since it is not worth it for him to do another operation overtime due to the high tax burden.
Proponents of progressive taxation are mostly based on utilitarian arguments: that each added unit of money has less value for someone who already earns a lot compared to someone who earns little. This is also logical: to someone who earns a minimum of less than 400 euros per month and gets a 10% raise, those additional 40 euros will mean more than to someone who earns 2,000 euros and gets an additional 200 euros in the form of a 10% raise. If the tax system then takes a little more from those who earn more, then there is room for those who earn less to take less through taxes. This should reduce the inequality in society that inevitably arises due to different abilities, opportunities, choices and even just luck in life.
It’s not all about the tax system, it’s also about tax rates
This point of view that proportional rates mean economic efficiency in contrast to progressive rates (which have a stronger negative impact on economic trends) is still not enough by itself because it leaves aside the issue of tax rates. For economic efficiency and acceleration of economic growth, is it better to have a proportional tax with a rate of 40%, or a progressive tax with rates of 10% and 15%? Almost certainly the latter. But again, it is almost certainly better to have proportional with rates of 20%, than progressive with 15%, 20%, 30% and 40%.
Also, pure proportional or progressive tax systems are rare. In a large number of countries in the world there are mixed systems where income from wages is taxed in systems that have the characteristics of both progressivity and proportionality. For example, there is only one tax rate that applies to all income levels, but therefore there is a high tax-free amount of earnings, so the effective tax rate that is actually paid depends on the amount of earnings.
Various tax exemptions, deductions or credits are also common, most often for dependent members of the household, such as children or an unemployed spouse – in this case progressivity will exist even with the same level of earnings, or someone with a higher income will pay an even lower effective tax rate, depending on the family situation. Through these tax deductions, it is possible to conduct various types of partial economic or social policies – in some countries, expenses for education (e.g. college tuition) or housing (interest on a housing loan) are tax exempt, which makes investing in education and creating human capital cheaper. , or makes the journey to the family home easier.
The experience of the countries of Central and Eastern Europe
This debate about the qualities and effects of proportional and progressive tax systems was alive during the 1980s in developed countries, which then began the process of reducing the high progressive tax rates that had been introduced in the decades after World War II.
The highest tax rate was recorded in Sweden, as high as 102% for the highest incomes (yes, if you earned an amount above the set limit, you not only had to pay it all as tax but also added more money to it), which writer Astrid Lindgren, author of a series of children’s novels about Pippa Longstocking, felt it on her own skin.
At that time, the USA was not far behind either, with the highest tax rate of 91%, which was lowered to 77% in 1964. The Reagan administration reduced tax rates in the US, and that move was followed by a number of primarily European countries (including, in addition to Great Britain, France and Germany, even the aforementioned Sweden).
Tax systems in these countries remained progressive, but tax rates for the highest incomes were significantly reduced. Such a tax policy was one of the key economic reforms that accelerated economic growth in those countries in that period after stagflation.
When CEE countries started their transition in the early 1990s, tax policy was one of the important elements of their success. They also had a debate about progressive and proportional taxation. At that moment, the majority of countries had decided that the policy of redistribution was something of secondary importance in relation to the policy of creating this value.
Simply, these countries were poor and there was not much to share. The first country to introduce a proportional income tax was Estonia, and when it was seen that this kind of reform had good economic results, other countries followed suit: first the Baltic countries (Lithuania and Latvia), and then Romania and Hungary, Slovakia and Bulgaria. Poland and Slovenia remained the only CEE countries that had and maintained a progressive tax system from the beginning. A good tax environment is one of the reasons for the arrival (and stay) of foreign companies, but also the development of the domestic sector of the economy, which resulted in the transformation of these economies and the growth of standards through the growth of productivity and wages.